China Threatens 'Nuclear Option'

Good day… The dollar ended the day yesterday a little weaker than we started after a big news story on China made the rounds on the trading desks. But the dollar had an abrupt turn around as Europe opened and fears of the spreading credit crunch gripped the European markets. So as I write this morning, the dollar is right about where it was at this time yesterday. I’ll start with Chuck’s analysis of the China story:

“Well folks… There was a BIG STORY that hit the news wires yesterday, and it’s a scary story for the United States and the dollar… I have to say that over the past two years I’ve warned the politicians in this country about their insistence on placing tariffs on Chinese exports. My warning in case you forgot was that there was no need to get the Chinese riled up at us, considering the $1.3 trillion in U.S. Treasuries that they hold… And, if they headed for the exits, don’t you think the rest of Asia would be fighting to get to the exits too?

“OK… So now that I’ve reminded you of what I’ve been warning… A BIG STORY hit the newswires yesterday… I won’t beat around the bush any longer here it is… From the U.K. Telegraph…

“‘China threatens “nuclear option” of dollar sales’ By Ambrose Evans-Pritchard.

“‘The Chinese government has begun a concerted campaign of economic threats against the United States, hinting that it may liquidate its vast holding of US treasuries if Washington imposes trade sanctions to force a yuan revaluation.

“‘Two officials at leading Communist Party bodies have given interviews in recent days warning – for the first time – that Beijing may use its $1.33 trillion (GBP658bn) of foreign reserves as a political weapon to counter pressure from the US Congress. Shifts in Chinese policy are often announced through key think tanks and academies.

“‘Described as China’s “nuclear option” in the state media, such action could trigger a dollar crash at a time when the US currency is already breaking down through historic support levels.

“‘It would also cause a spike in US bond yields, hammering the US housing market and perhaps tipping the economy into recession. It is estimated that China holds over $900bn in a mix of US bonds.

“‘Xia Bin, finance chief at the Development Research Centre (which has cabinet rank), kicked off what now appears to be government policy with a comment last week that Beijing’s foreign reserves should be used as a “bargaining chip” in talks with the US.’

“Hmmmm… I don’t think anyone, including yours truly, that wants to see that happen… But I kept warning them, and warning them… But like a stubborn child, they refused to listen…

“This BIG STORY caused some dollar weakness… But not as much as you would expect… However, we could definitely be seeing a classic example of buy the rumor and sell the fact… For now… It’s just another sharpening of the Damocles Sword, which hangs over the dollar in my opinion!

“Yes… Even though I warned about this… I really think that before China would go about holding a fire sale of Treasuries, we’ll see more of the same, slow movement in the renminbi (CNY)…”

As I said in the opening paragraph, this news story caused a pretty sharp sell off of the dollar which lasted through Asian trading. But at the opening of the European markets, BNP Paribas SA, France’s biggest bank, froze three investment funds. This reignited concern that the U.S. subprime mortgage crisis is spreading and prompted traders to unwind their trades.

Adding fuel to the fears, NIBC Holding NV, a Dutch investment bank, posted losses on subprime mortgages. This comes on the heals of last month’s announcement of major losses by the Australian hedge fund, and many warnings by major German banks of charges due to investment losses.

Credit-default swap rates, a benchmark for the cost of protecting bonds against default and speculating on credit quality increased 6.5 basis points in London. An increase of these spreads indicates worsening perceptions of credit quality. BNP Paribas had to halt withdrawals from three investment funds because it couldn’t “fairly” value their holdings. Basically, there was no one who would bid on the subprime bonds, so the funds couldn’t estimate their value. NIBC said it lost at least 137 million euros and expects further losses on its investments in U.S. asset backed securities.

Unlike our own Fed, the ECB didn’t stay on the sidelines. They issued a statement that said it “stands ready to act” to assure “orderly conditions” in the euro money market. The ECB followed up this statement with action, as it supplied much needed liquidity to the credit markets by accepting all bids for funds at a 4% rate. This again illustrates the dramatic differences between our two central banks. The ECB got out in front of the problem, provided the markets with much needed liquidity, and calmed the markets. Meanwhile the Feds official stance during this entire subprime debacle reminds me of Bobby McFerrin’s Grammy award winning song “Don’t Worry Be Happy”.

Investors were singing right along with our Fed leaders as they were again flocking back into the carry trades after the Fed left rates unchanged. But the subprime mess is here to stay, and it has tentacles that reach far into global investment markets. As quickly as these investors moved back into the carry trades, they turned around and moved their investments back out of the high risk assets, paying down some of their loans in yen (JPY) and francs (CHF), and moving funds back into U.S. Treasuries.

As expected, the biggest winners in this reversal were the two traditional funding currencies of the carry trade, the Japanese yen and the Swiss franc. The yen rose to 118.50 against the dollar from a low of 119.70 yesterday. The Swiss franc advanced on both carry trade reversals and their status as a safe haven.

Switzerland’s currency is often favored in times of economic tension. “We’re seeing risk aversion and higher volatility in the market with the banks citing losses,” said Marcus Hettinger, a currency strategist at Credit Suisse Group in Zurich. “This proves the franc is still a safe-haven currency.”

Investors wanting to take advantage of this move back to safety can invest into the Swiss franc individual CD for 3, 6, or 12 months; or you can also get Swiss franc exposure by investing into the Euro-Trax Index CD. The Euro-Trax is split 40% euros, and 20% Swiss francs, Norwegian krone (NOK), and Swedish krona (SEK). Either of these investments is an excellent way to protect your portfolio against both the reversal of the carry trade and the fall of the U.S. dollar.

Standard & Poor released a report yesterday stating the growth of the Australian economy will remain “decidedly positive”. S&P raised its predictions for expansion of the Aussie economy to 3.8% from an earlier estimate of 2.8%. According to the report, Australia’s mining industry is spurring the nation’s expansion as they meet the increasing demand for minerals from China and India. Demand for commodities from China and India, two of the world’s fastest growing economies, is fuelling record output and a surge in profit for exporters. Australia is the world’s largest iron-ore exporter and raw materials make up 60% of the country’s export earnings.

The employment report released today in Sydney gave further evidence of the strength of the Australian economy. Australian employers hired extra workers for a ninth consecutive month in July, worsening a labor shortage that is driving up wages and inflation. Employment rose 21,800 from June and the jobless rate remained at 4.3%, close to a 33 year low. This report confirms the need for the interest rate increase which was announced by the RAB yesterday.

Global growth is strong, and inflation will continue to push central banks to raise rates. Central banks in England, Canada, New Zealand and Australia all raised rates in the past month amid booming global growth. And where is the U.S. Fed during all of this? Sitting on the sidelines! With global rates rising, and the U.S. rates stuck in a holding pattern the dollar will continue to trend down. Protect yourself from the dollar’s inevitable slide by moving investments out of the greenback and into foreign currencies.

Currencies today: A$ .8548, kiwi .7576, C$ .9479, euro 1.3730, sterling 2.0266, Swiss .8358, ISK 64.27, rand 7.097, krone 5.7823, SEK 6.7481, forint 182.35, zloty 2.7492, koruna 20.495, yen 118.76, sing 1.5150, HKD 7.8231, INR 40.535, China 7.5652, pesos 10.9724, dollar index 80.554, Silver $12.97, and Gold… $668.10

That’s it for today…Happy Birthday to our head trader of late, Kristin Kuchem. Kristin has done an amazing job stepping up to fill in for both Chuck and Jennifer during the past month and a half. Looks like another 100 plus day here in St. Louis. Have a great Thursday, stay cool!!

Chris Gaffney
August 9, 2007